Tuesday, April 19, 2011

I keep coming back to the issue of money, QE2, and inflation because it is so important.

Here's a summary/clarification of my most recent post on the subject, as well as other related comments I've made along the way:

The Fed has expanded bank reserves and the monetary base massively, creating the potential for hyperinflation. (In our fractional reserve banking system, each new dollar of reserves potentially can support about $10 new dollars of bank deposits.) But so far, none of this "money printing" has shown up in traditional measures of the money supply (e.g., currency, M1, and M2), which display no unusual level of growth in recent years. (In fact, they are growing at a much slower rate today than they did in the inflationary 1970s.) Indeed, virtually all of the reserves created by the Fed to pay for its security purchases are sitting idle, in the form of excess reserves, at the Fed.

Without a huge increase in the actual amount of money in the economy, we are unlikely to see a huge increase in inflation. Alternatively, a significant decline in the demand for money could support a rise in the price level, but there is no evidence to date that this is occurring (except for the fact that the dollar is trading at record lows).

Meanwhile, market-based and leading indicators of inflation strongly suggest that the Fed has supplied more money to the world than the world wants (e.g., the extreme weakness of the dollar, soaring gold and commodity prices, the very steep yield curve, and rising breakeven inflation rates on TIPS). It is an over-supply of money that debases a currency's value, leading to a general rise in the price level, just as an oversupply of houses relative to housing demand has led to a significant decline in housing values in recent years.

So while there is no obvious evidence that the Fed has committed a major inflationary faux pas, there is evidence to suggest that inflation is headed higher. And although banks have yet to utilize their huge stock of excess reserves to greatly expand the money supply, there is no reason to think that won't happen in the future, nor any compelling reason to think the Fed will be able to respond (by cancelling QE2 and/or withdrawing reserves) in time to prevent banks from doing so (e.g., how aggressive can the Fed get if the economy is still struggling to recover?). Conclusion: investors need to be prepared for higher inflation, but there is no reason yet to panic.

The chart below shows a 16-year history of M2, in order to underscore the point that to date, there has been no unusual expansion in the amount of money sloshing around the economy. M2 has grown about 6% per year on average since 1995. Over that same period, the GDP deflator (the broadest measure of inflation) has risen about 2% on average, and real GDP has increased about 4.6% per year on average (all compounded, by the way). In other words, the amount of money in the economy actually has grown by a little less than the growth in the nominal size of the economy (i.e., 6% vs. 6.7% per year).

There are still some important questions to be answered, however. How can there not have been any new money printed, if the Fed has purchased almost $1.5 trillion of Treasuries and MBS since late 2008? What happened to the $1.5 trillion that the sellers of those securities received? Can the quantitative easing process continue indefinitely without inflationary consequences? What will happen if/when quantitative easing stops?

The short answer to the first question (why no new money?) is that at the end of the day, two things happened: 1) banks were willing to hold on to the new reserves, and not use them to increase their lending, and 2) the world in aggregate did not want to increase its dollar borrowings. Another way to put this is that the extra reserves satisfied the world's demand for additional safe and liquid assets. At the same time, the Fed effectively swapped reserves (a kind of T-bill equivalent) for T-Notes and MBS, thus shortening the maturity of federal debt and reducing the private sector's exposure to rising interest rates.

Can this continue indefinitely without inflationary consequences? I doubt it. But there is a certain vicious-cycle aspect to all this that is troubling. The more the government borrows (with the federal deficit on track to hit 10% of GDP, a very large number by any standard), the more the government spends; the more the government spends, the less efficient the economy becomes; the less efficient the economy, the slower it grows; the slower the economy, the fewer attractive investment opportunities there are, and thus the more attractive Treasury debt becomes, even if interest rates are very low relative to inflation. This same dynamic may help explain why Japan has had deficits of more than 10% of GDP for many years, yet the yields on government bonds remain extraordinarily low and economic growth has been disappointingly slow.

Is the end of quantitative easing going to be painful? Not necessarily. The end of QE2 means only that the Fed will stop swapping reserves for longer-maturity securities. There will still be a mountain of excess reserves in the system. Even if the Fed were to start "tightening" immediately after the end of QE2, that "tightening" would hardly be considered problematic, since it could take years to reverse all the injections of reserves. And in lieu of actually reverse its reserve injections, the Fed could simply decide to pay a higher rate of interest on existing reserves. This would have the effect of raising short-term interest rates without reducing the supply of reserves. The steepness of the yield curve is proof that the market is already braced for short-term interest rates to rise by hundreds of basis points. The issue is not whether the Fed will tightening or by how much they will tighten; the issue is when and how fast they will start raising rates.

It is entirely conceivable that a rise in interest rates that results from a Fed tightening will have the effect of increasing the world's demand for longer-maturity securities, thus obviating the need for the Fed to continue swapping reserves for longer-maturity securities.

I hope it's clear that I'm trying to take an objective and dispassionate view of things. There is reason to be concerned, but not yet any reason to panic.

UPDATE: I want to clarify my views on inflation, since on the one hand I argue that the Fed hasn't committed an obvious monetary policy error (because M2 growth is still normal), but on the other hand I note the symptoms of rising inflation (weak dollar, rising gold and commodity prices) and worry that it will continue to rise. Contrary to what some conclude, I am not saying we don't have an inflation problem. I think that 6% M2 growth, if it persists, will be a strong force limiting the rise in reported inflation to 10% at the most, but even 5-6% inflation is enough to qualify as a problem in my book. With 6% M2 growth, inflation could exceed 10% only if we see a meaningful decline in money demand (M2/GDP) and a pickup in M2 velocity (GDP/M2). That is not impossible at all, but it has yet to occur.

I read with close interest and admiration all Scott Grannis' posts, but especially those dealing with QE.

I fall into the camp that does not like federal deficit spending, but is all for an aggressive, expansionist Fed. We see in Japan what a monetary noose can do to a nation's economy. A feeble, dithering Fed is disaster.

Price stability at the cost of prosperity and investor returns is a crappy choice. Again, see Japan. I will take some inflation--no choice in life is perfect.

Bob McTeer, former Dallas Fed head, if calling for a bump in interest rates but also QE3.

My overall sense is that now is not the time to fight inflation, but rather do everything--regulations-wise, tax-wise--to spur business growth.

And we nned to trim federal outlays. Entitlements, defense spending, just have to take a back seat to debt reduction. Throwing money at every perceived risk, domestic or foreign, has just got to stop.

Could you elaborate on what the US Treasury is doing? Is it still primarily selling short term debt or has it gone further out the Treasury yield curve to take advantage of the historically low long term interest rates. My concern is that the short end is very tempting when it is less than 1% but it could be a problem when yields inevitably rise. Do you know if the Treasury is repositioning to take advantage of the long end?

Just wondering how smart the Treasury has been in financing our gigantic debt. Do you foresee any problems there as the Federal Reserve changes course?

I don't have the numbers in front of me but I'm pretty sure that Treasury has been shortening the maturity of their security sales. This has been a good thing since short-term rates are so low, but it will be very expensive if and when rates start to rise. It would have been more prudent to extend maturities.